I knew absolutely nothing about John Quiggin, until someone asked me to write a short review of Zombie Economics for the Journal of Economic Literature. The timing was good, as I was about to leave for Australia to give a plenary talk at the Australian Conference of Economists in Canberra in July. I could read the book on the plane (though a trip from St. Louis to Chicago would actually be sufficient) and might actually come across the man himself, or news of him, at the conference.

By the time I got to Canberra, I had read Zombie Economics, and had written a draft of my review which panned the damn thing (more on that later). I was a little lost at the conference as none of the Australian economists I know showed up, but Pete Klenow was there, and I sat down at dinner with Max Corden, who is one of the most engaging people I have run into in my life. Between courses at dinner, various awards were presented, and at one point we got to an the annual award of Distinguished Fellow of the Economic Society of Australia. Previous recipients included my dinner companion Max Corden, Trevor Swan (he of the "Solow-Swan model"), and Murray Kemp. Who did the 2011 award go to? John Quiggin.

What is Quiggin's claim to fame? His early work is an odd mix of agricultural economics and decision theory, but he seems to have distinguished himself mainly in public policy. He writes regularly in the mainstream media, writes a blog, and Zombie Economics appears to have sold well.

Now, what is Quiggin up to in Zombie Economics? Roughly, Quiggin is the Australian farm team in the Krugman/Thoma/DeLong league. Quiggin argues that there are five key "zombie ideas" that have been used by conservative economists for ideological purposes. The financial crisis has showed us that, without question, these ideas are wrong. Nevertheless the ideas, like zombies, continue to walk. If you read the book, you'll see why it could sell well in airports. However, I would recommend Life by Keith Richards (which is the last book I bought in an airport) over Zombie Economics any day. Keith is much more interesting, and the economics is better.

The Great Moderation: Quiggin is a little confused on this one, as the Great Moderation simply characterizes a set of properties of US aggregate time series. From about 1985-2007, inflation was lower and less variable, and real GDP was less variable about trend than had been the case previously. Quiggin is certainly correct, though, in finding fault with those (Ben Bernanke included) who wanted to argue that the Great Moderation was due to a regime change in economic policy. If policy was so great, it should have done a better job over the last four years.

The Efficient Markets Hypothesis: For Quiggin this is "the idea that prices generated by financial markets represent the best possible estimate of the value of any investment." Here, Quiggin is badly confused, but maybe the finance practitioners are not helping him out much. Market efficiency is simply an assumption of rationality. As such it has no implications. If it has no implications, it can't be wrong.

Dynamic Stochastic General Equilibrium: Quiggin claims that this is "the idea that macroeconomic analysis should not concern itself with economic aggregates like trade balances or debt levels, but should be rigorously derived from macroeconomic models of individual behavior." I can hear you snorting with laughter. Why is "but" in that sentence? Like the "efficient markets hypothesis," DSGE has no implications, and therefore can't be wrong. Indeed DSGE encompasses essentially all of modern macroeconomics. Which of our models is not dynamic, with uncertainty (and therefore stochastic), and with some equilibrium concept. Indeed, many of them incorporate trade balances and public and private debt. Granted, some of our models were not so helpful in making sense of the financial crisis. But others were, and some of the models that were not helpful could be (and are being) modified so that they are.

Trickle-down economics: This one puzzled me. For the previous three zombie ideas, Quiggin is confused, but I could see where the confusion might come from. However, while the words "trickle-down economics" are familiar to me, I have a hard time associating that idea with the mainstream ideas of any academic economists. On some level, it seems obvious that economic growth benefits all residents of a country. Whatever my skill set, I would rather ply my trade in the United States than in Malawi. While there may exist serious barriers to economic mobility in the United States that we should be addressing, the financial crisis does not somehow point out some serious deficiencies in how economists think about the income and wealth distributions.

Privatization: Here, Quiggin offers a litany of government privatization efforts gone awry. If I wanted to, I could take this evidence as supporting the hypothesis that government is really bad - so bad that it can even screw up privatization.

So, the heart of economic thought is a set of zombie ideas that should die a miserable death. But to be replaced by what? Quiggin is pretty vague about this. He thinks that "heuristics and unconsidered assumptions inevitably play a crucial role," and that economics should focus "more on realism, less on rigor." Eureka. We need some sloppy, realistic, heuristic models with unconsidered assumptions.

It's unfortunate that some of the people who write so much about economics for the general public spend so little time reading about what economists actually do, and attempting to understand it. No wonder people are confused.

68 comments:

While I agree with much of your take on Quiggin's views, I think you dismiss the policy interpretation of the Great Moderation a little too quickly. The idea that monetary policymakers have gotten better at stabilizing the economy does not imply that large business cycles cannot still occur even in the presence of improved policy. Indeed I suspect that monetary policymakers' response in the Fall of 2008 substantially mitigated the fallout from the financial crisis. The question is really whether volatility would have been the same during the last few years had Burns and his ilk been in charge of the Fed. I suspect the real effects would have been more severe without someone like Bernanke in office. In any case, the occurrence of one large financial crisis and recession does not necessarily imply the end of the Great Moderation.-C

Certainly any model can't be wrong if it's internally consistent, but you can make wrong, highly inaccurate, implications/conclusions from the model to reality and to policy. There is certainly a danger of making overly literal interpretations and conclusions from a model to reality.

"Market efficiency is simply an assumption of rationality. As such it has no implications. If it has no implications, it can't be wrong."

There are implications made in academic finance from the market efficiency assumptions, and these implications are referred to as market efficiency. From memory, these include stock prices/returns aren't predictable, for example you can't predict higher then trend returns from lower PE ratios, and the CAPM conclusions if you add some other assumptions. Empirical studies have gone against these.

On DSGE: You haven't understood. DSGE encompasses a very broad class of models, indeed it's almost the universe of macro models. Those models have some very different implications, as could DSGE models we have not dreamed up yet. Thus, you can't say that "DSGE" has any particular implications.

On market efficiency: Yes, the testable predictions come from additional assumptions. Risk neutrality implies the prices are martingales. Representative agent, time-separable utility, risk aversion, implies that the marginal utility of consumption is a martingale. Again, rationality on it's own does not imply anything.

Richard: "From memory, these include stock prices/returns aren't predictable, for example you can't predict higher then trend returns from lower PE ratios, and the CAPM conclusions if you add some other assumptions. Empirical studies have gone against these."

First, as Steve's answer implied, one can have some predictability even in efficient markets. For example, there can be a time varying risk premium on equities. Only very strong--implausible--assumptions imply zero predictability.

The amount of predictability found by even the most "optimistic" studies is very low by ordinary standards. For example, if one gets an R squared of 1/2 percent in monthly stock returns, one has done very well.

Second, as Campbell, Lo and MacKinlay pointed out years ago, market efficiency is not a binary variable. Markets cannot be perfectly efficient; economists seek to measure the degree and nature of inefficiency.

Third, as Schwert has documented, many/most/all(?) alleged documented violations of market efficiency actually disapear after the original sample. I don't want to push this point too hard, but it seems to me that markets actually adjust pretty well to eliminate documented inefficiencies.

Quiggin is a joke- the only "zombie" idea this recent mess has brought back is discretionary fiscal stimulus.

The last one in particular (privatization) is a real "wait is he being serious" level thing. It's not conservative economists that advocate privatization... it's the vast vast majority of anyone and everyone that's taken at least a minimal glance at the peer reviewed empirical growth/development literature.

This kinda summarizes him for me: "more on realism, less on rigor". Where "realism" is inevitably silly ideologically motivated quasi-sociology junk injected into economics... Realism as in "Real World Economics Review" real. Yikes.

I'm happy to take some heterodox growth/development types seriously- Dani Rodrik is a bit out there and has been traveling further out there- but he publishes serious, quality academic work to spread his ideas, not silly popular writings.

One more thing: Despite the fact that a high percentage of papers in financial economics are devoted to finding deviations from it, I think that the efficient markets hypothesis is actually an excellent benchmark from which to start understanding financial markets.

It is not the whole story, but it is a decent approximation for most purposes.

Serlin is right about the EMH literature, which has a complex "adaptive" space and which originated out of _empirical_ finding and considerations.

Stephen, as usual, exhibits what I would call shocking incompetence when it comes to the specialized literatures of economic thought.

It's unfortunate that some of the economists who write about economics for blogs spend so little time reading what leading economists have actually produced over the years -- and spend almost no time at all attempting to understand it. No wonder that people like Stephen are so confused about what economic science can and has achieved -- or what it hasn't and can't achieve.

I made similar points to yours on quiggin’s blog that ‘government is really bad - so bad that it can even screw up privatization.’

The most basic and simple task of owning an asset is selling it. Advisors can be hired to run the auction process for you.

Governments sell commercial assets in the full blaze of publicity and close scrutiny from the opponents of privatisation and still screw it up.

governments under-price the process to favour small share buyers, employees and other constituencies. Quiggin did not respond to this public choice argument.

Quiggin focuses on a blackboard economics argument about state owned enterprises might be subject to a soft budget constraint and waste but they can more than offset this waste by borrowing their capital for less – at a risk-free rate - because they are government guaranteed. This argument seems to justify government ownership of all firms

The portfolio of state owned enterprises in New Zealand earns well below the long-term bond rate.

“Market efficiency is simply an assumption of rationality. As such it has no implications. If it has no implications, it can't be wrong.”

This is merely echoing what John Quiggin himself says:

“But the ultimate response to this invulnerable zombie must be the same as Popper on Freudian psychology. If the Great Depression, the dotcom boom and bust and the current Global Financial Crisis are all consistent with the efficient markets hypothesis, the hypothesis can’t tell us much of interest about anything. At most, it says that even when markets are way out of line with economic reality, it is hard to exploit this fact to make a profit. Most of us (me and Krugman at any rate) already knew that, and confined ourselves to getting out of stocks when they seemed absurdly overvalued.”

He doesn’t bother with weak versions of the EMH, since they are quite vacuous. It’s the strong version regularly peddled in the press that he objects to.

Don’t feel too bad about the fact that you haven’t heard of him. It’s a big world. If it wasn’t for Mark Thoma I don’t suppose I’d ever have heard of you. Apart from the award you mention, John Quiggin is a Fellow of the Econometric Society. Just a few days ago he received a further distinction, a sliming in the Murdoch press.

In the first comment, C is surely pulling our legs. Poorly executed monetary policy is one strand in creating our current disastrous economic environment. This argument was made by William White at the BIS back in the early 2000s. So for C to commend the Fed for fighting the GFC in 2008 is shall we say disingenuity of a high order. And indeed the results of those interventions may yet themselves be leading to even more instability.

I've never been convinced when people make the argument that a low fed funds rate in the early 2000s helped bring on the crisis. You might argue that the incentive problems that existed in the mortgage market in the early 2000s were exacerbated by low real interest rates. i.e. low short-term interest rates made what was essentially theft more profitable. But to what extent was the Fed responsible for the low real rates, and what was the result of conditions on world credit markets. Ultimately though, the fundamental problem had to do with mortgage market regulation, systemic risk, and other dimensions of financial regulation. Of course, some of that was the Fed's responsibility, but I have my doubts about monetary policy as a cause.

1- As Stephen suggests, there is little real evidence that the low rates of the 2000s played a large role in driving housing prices. At this point, this is pure speculation.

2- More importantly, the shocks to the financial system this time was much larger than those at the start of the Great Depression. So why didn't we get a Great Depression this time around? Friedman and Schwartz made a persuasive case that the key factor in the GD was the absence of a monetary policy response. This time, we had an even bigger shock to the system, but aggressive monetary policy which helped avoid a GD. So yes, I still buy the fact that monetary policy has been much better than in the past and has been a stabilizing force since Volcker in a way that it was not before.- C

1. "the shocks to the financial system this time was much larger than those at the start of the Great Depression." How do you measure that?

2. The Great Depression was very different. The liquidity shock in that case was closely related to what you see in earlier National-banking-era financial panics. It's essentially a currency shortage. The recent financial crisis is quite different. The liquidity shortage in that case is a shortage of safe assets generally - particularly a shortage of safe assets in large financial trades. It's not clear what the world would have looked like in the absence of Fed intervention during the crisis. It will take a lot of work to figure that out.

Anon 9:23 pm: "Serlin is right about the EMH literature, which has a complex "adaptive" space and which originated out of _empirical_ finding and considerations."

Perhaps you could translate that into English for us.

If English isn't your native language, just write it in Urdu or Japanese or whatever and go to Babelfish to get it machine translated.

Anon 9:23 pm: "Stephen, as usual, exhibits what I would call shocking incompetence when it comes to the specialized literatures of economic thought."

This is not only unnecessarily nasty, it is vaccuous. You provide no examples, no evidence.

Anon 9:23 pm: "It's unfortunate that some of the economists who write about economics for blogs spend so little time reading what leading economists have actually produced over the years -- and spend almost no time at all attempting to understand it. No wonder that people like Stephen are so confused about what economic science can and has achieved -- or what it hasn't and can't achieve."

Wow, that's a lot of words to say that you don't like Steve's blog.

You should try to make a reasoned argument -- with evidence -- on a specific point on which you disagree with Steve. You might actually convince someone, maybe even Steve!

Among the predictions of any model is its assumptions. So one of the predictions of the EMH is that people are rational. This assumption could conceivably be wrong. So the EMH could conceivably be false. You are trying to reduce to a tautology what is a strong behavioral assumption.

If "scientists" don't know any of this, shame on them. And go read a book, please, and stop spreading ignorance on the interwebs.

Wikipedia touches on many of the facts of the history of this train of research in it's entry on Efficient Market Hypothesis in the Historical Background section -- enough to settle this issue & end the nonsense.

Reading the comments at crooked timber, its quite clear that your essential points are frequently lost in between your rhetorical slamming. I have to try real hard to skip over the innuendo in your blog and get to the usually well reasoned critiques. You might have your problem with Krugman/Delong. But, stop behaving as though the whole world belongs in that camp. Your brand of macro is pretty far from the mainstream (as indicated by your citation count and your text book sales). You might have a better time convincing people of your ideas if you toned down the angry rhetoric and focused on your ideas. Just a suggestion.

1. "Among the predictions of any model is its assumptions. So one of the predictions of the EMH is that people are rational. This assumption could conceivably be wrong. So the EMH could conceivably be false. You are trying to reduce to a tautology what is a strong behavioral assumption."

3. There is a lot of confusion here about the "efficient markets hypothesis." I think my take on this might be different from how your average finance person thinks about it (or maybe not). To get implications about the behavior of asset prices you need a model. Simple economic models of asset pricing start with optimizing behavior, impose equilibrium, and then derive some equilibrium relationship (typically an Euler equation) that characterizes the behavior of asset prices. Now, those asset prices will in general depend on a lot of things: preferences, endowments, technology, the equilibrium concept, who trades with who, what the information structure is, etc. We can play around with those components to find out how this matters for the behavior of asset prices. That's finance, and much of financial economics. What's Quiggin arguing? That we should throw all that out because the financial crisis happened?

I know. That doesn't mean it is true, which is the assumption of the EMH. As I said, you are committed to a strong proposition - there is no such thing as a mistake - and you regard it as a truth as indubitable as the law of noncontradiction.

I think that's the bare minimum you need to even begin studying the behavior of human beings. Without rationality, you might as well go home and forget it. Quiggin, for example, knows something about decision theory - for example alternatives to expected utility that give you different ways of thinking about choice under uncertainty. But those alternatives don't abandon rationality, which is very weak indeed. Rationality just says you can actually study the behavior and find some regularity in it.

"You are confusing necessary and sufficient conditions." I'm not. Note that Steve is saying "I think that's the bare minimum you need to even begin studying the behavior of human beings". This is the position that without rationality there are no regularities.

The point is this. Steve's idea of rationality is so trivially weak it's close to a tautology, and yet strong enough to imply regularities worth studying. I don't think these demands can be satisfied simultaneously. As soon as your notion of rationality has enough structure to predict regularities, it has enough structure to be falsifiable.

It can't be trivially true that people are rational, if rationality implies regularities worth studying.

Steve seems to think that some models are literally the way the world works. This is outside the mainstream of academic economics, and he shouldn't represent it as such. I have the more traditional economists' view that all models are wrong but some are useful.

Also, the definition of a mistake is relative to some definition of rationality. I'm saying that no-one has ever made a mistake relative to Steve's definition of rationality, according to Steve. And if this is true then his notion of rationality is too weak to provide a basis for scientific enquiry.

"rationality means that in the history of the world, no-one has ever made a mistake."

Wrong.

"Steve seems to think that some models are literally the way the world works."

Wrong as well. If it's a model, it's wrong. It can help us organizing our thinking about the world, and it might be useful for making predictions or conducting policy, but as the model is necessarily an abstraction, it's going to be wrong on some dimensions.

Whatever you may mean by rational, it means "not making mistakes" for some definition of mistake. Interpret my use of "mistake" accordingly. Then "people are rational" means "people don't make mistakes".

You may say that this statement is empty. That's precisely my point. If you really believe people are rational all the time your idea of rationality is so weak as to have no scientific content. I notice you didn't respond to this point.

Yes, but that's a low bar to pass. You could pass that bar and still have some very inaccurate pricing and resource allocation.

Look at the housing bubble. Prices got very high relative to people's incomes and rents in 2005. It was a very poor time to buy and a very good time to rent. The normal reply is that those prices were efficient because if they weren't then smart skilled informed traders would push them to efficiency. But you can't short sell most real estate, and the vast majority of homebuyers have very little knowledge of finance.

Take the stock bubble of the late 90s. There, you could do a lot of short selling, so the claim is the prices would then be efficient because even if only a small minority of investors is highly expert and well informed they would just keep buying or selling until prices were what they thought were fair. But how much money does this minority of investors with high expertise and high public knowledge have? Enough to push the prices how far to where they think they should be before they run out of money? Because the majority of money in the market is from people with very little of the relevant public knowledge in their brains and very little of the expertise needed to analyze it well.

Plus, the minority of people who have a high level of public knowledge in their brains plus the expertise, education, and training to analyze that information well are limited by undiversification costs; from a letter I had in "The Economist's Voice":

...One reason which was missing, at least explicitly, and which I have not seen yet in the literature, at least explicitly, is that a smart rational investor is limited in how much of a mispriced stock he will purchase or sell by how undiversified his portfolio will become. For example, suppose IBM is currently selling for $100, but its efficient, or rational informed, price is $110. It must be remembered that the rational informed price is what the stock is worth to the investor when added in the appropriate proportion to his properly diversified portfolio of other assets. Such a savvy investor will purchase more IBM as it only costs $100, but as soon as he purchases more IBM, IBM becomes worth less to him per share, because it becomes increasingly risky to put so much of his money in the IBM basket. By the time this investor has purchased enough IBM that it constitutes 20 percent of his portfolio, the stock may have become so risky that it’s worth less than $100 to him for an additional share. At that point he may have only purchased enough IBM stock to push the price to $100.02, far short of its efficient market price of $110. Thus, if the rational and informed investors do not hold or control enough—a large enough proportion of the wealth invested in the market—they may not be able to come close to pushing prices to the efficient level.

And as far as anomalies resolving, some have, some haven't, and some have, but then have come back. For a good exposition see, "The New Finance" by Robert Haugen, formerly of UC Irvine, and "The Limits of Arbitrage" in the Journal of Finance.

I'm not sure what you mean my mistakes. I have written down models where people are faced with some formidable problems, and they can screw up badly in equilibrium. People are untrustworthy (that's limited commitment), you may lend to some goofballs, things are bad enough in the aggregate that the government should fix things in various ways. You don't have to be afraid of rationality. It's not evil.

I'm only making one point. If one says "Rationality is very weak, to the point of being unfalsifiable" and "Rationality yields regularities in behavior which economists can analyse", one must mean different things by "rationality" in these two sentences. I think you may agree with this point, in which case there is no disagreement between us.

I'm not sure if we're disagreeing or not. Let's give it another try. Rationality is doing the best you can under the circumstances. But that in itself does not put any restrictions on what I should observe people doing. In terms of modeling and economic science, we get implications and testable restrictions from the circumstances, not the rationality.

trickle-down,

On the north side of St. Louis, poverty is appalling, and it seems we could use our ingenuity to make those people better off, ultimately at no expense to the rest of society. However, if you offered a north St. Louis resident the option of moving to Malawi permanently (expenses paid), I don't he or she would take it. That's what I'm getting at.

Expanding on this, this is saying that there are no perfect textbook arbitrages; free money, no risk – at all, no upfront money required – at all.

Again, a low bar to clear. There could still be many investments with far lower than average risk-adjusted expected returns, like stocks in the late 90's bubble, and many investments with far higher than average risk-adjusted expected returns, like in stock reverse-bubbles, where the average P-E has dropped as low as into the fours.

So, you could clear the low no perfect arbitrage $20 bill bar and still have very inefficient pricing, that is pricing that far from reflects the consensus of people with vast public knowledge in their brains and the many years of education, expertise, experience, and thinking time necessary to analyze it well.

"Making the case that a ready supply of gasoline caused the house to burn down is ridiculous. You could argue that the three jerry cans of gasoline on the electric blanket with the frayed cord next to the box of flares below the kerosene lamp being used by a 10 year old boy with divorced parents to read "Fahrenheit 451" while using a book of matches as a book mark were all part of the fundamental problem. But I have my doubts about gasoline as the cause."

This is pretty funny. Steve hasn't exactly covered yourself in glory here. Good advice from the last Anonymous. Take a few days off Steve. Soon this will blow over and eventually people will forget. You won't always be the guy who people point to in the street and say "He's the one who defended DSGE by saying it has no implications, and therefore can’t be wrong."

Like Prof W, I personally find Walrasian economics extremely beautiful and I am not sure why others cannot see the beauty. Pace the economist from the land of 3rd rate cricketers, Keynesian arguments are very ugly, and much more redolent of zombies.

Much confusion here, obviously. I don't think there is any shame in truth (and we're not in this game just to stare at beautiful models either). The confusion arises in part because "DSGE" means different things to different people.

3. DSGE is of course "dynamic stochastic general equilibrium." Arrow-Debreu is just a subset of DSGE then, as some DSGE models do not have complete markets.

You have to make inferences here, but I think Quiggin thinks DSGE is (1). From my point of view, it's (3). Basic Arrow-Debreu on its own has no implications, so certainly the broader class of DSGE models has none.

I think you're quoting Quiggin out of context on the "heuristics" quote above. In the Kindle edition of the book (listed as page 124 of the print edition) the full quote is:

'On the contrary, economic behavior, even that of highly sophisticated actors like the “rocket scientists” who design financial instruments for investment banks, is inevitably driven by a partial view of the world. Heuristics and unconsidered assumptions inevitably play a crucial role. For finite beings in a world of boundless possibilities, nothing else is possible.'

I think he's referring to unconsidered assumptions and heuristics made by people who make economic decisions, not by economists who are modeling them. So he's not saying (in this quote at least) that economic models should be based on heuristics and unconsidered assumptions, but rather that economists should measure what heuristics people actually use and incorporate those into their models.

What I really think? There is whole body of work on asset pricing in economics, beginning with work by Lucas (78), and Prescott-Mehra (85) studying the general equilibrium behavior of asset prices and how those predictions match the data. The basic models are pretty useful in organizing how you think about the problem. But the models don't fit the data very well, as a large body of work shows. Some of that might have to do with the role of assets in financial trade, some of which I have looked at, as have people like Guillaume Rocheteau and Ricardo Lagos. The financial crisis provides us, as researchers, with more data, and highlights the role of financial activity, but it does not tell us that we should dump that whole research program, as some kind of zombie idea.

If X and Y are statements, or propositions, we say that X implies Y (or, if you like, that Y is an implication of X) if and only if it is impossible for Y to be false when X is true. Given this definition, every proposition has implications. Trivially, every proposition implies itself. Moreover, some propositions, called 'tautologies', are necessarily true (e.g. 'If the sky is blue then the sky is blue'), and so they are implied by every proposition.

But let's restrict 'implication' to non-trivial implications. (X non-trivially implies Y iff X is distinct from Y and X is not a tautology.) Some propositions do lack implications in this sense.

Stephen seems to say the 'EMH' has implications only when combined with further assumptions. In that case, EMH does seem rather useless. Suppose X has no implications, but the conjunction of X with Y, i.e. X&Y, does have some implication, Z. Then Z must also be an implication of Y alone. So why bother assuming X at all? One will get the same result simply by assuming Y.